How to respond to the side-effects of demonetisation

The success of black money demonetisation initiative will inevitably create contractionary pressures on the economy in the near term. Policy measures, monetary and fiscal, are urgently needed to offset these contractionary impulses.

Specifically, if the demonetisation is successful, it will extinguish a substantial amount of currency in circulation (expectations range from Rs 2 lakh crore to Rs 5 lakh crore).

From an aggregate demand perspective, extinguishing currency in circulation is equivalent to a one-off tax and also leads to tightening of credit financing conditions i.e., it has a contractionary impact on aggregate demand and GDP (gross domestic product) growth. A particularly interesting offsetting, at least partly offsetting action for the government, is the direct transfer of funds to the newly-opened Jan Dhan accounts.

Why extinguishing currency in circulation is equivalent to a one-off tax

The currency notes that are extinguished end up as government revenue just as a one-off tax. Let us see how this happens.

Currency notes are liabilities of the Reserve Bank of India (RBI). So, extinguishing this liability is a profit for the RBI -as if a citizen that has lent money to the RBI has written-off the debt. The RBI is, of course, owned by the government. So, its profits eventually end up with the government as its revenue.

An alternative way to think about this is when a citizen holds currency he is indirectly holding zero interest rate government debt, with the RBI serving as an intermediary in the lending transaction. This happens because currency issued by the RBI (RBI's liability) is backed by government bonds (RBI's asset).

While the government pays interest on these bonds to the RBI, the interest amount goes back to the government as dividends from the RBI. So effectively, the government pays no interest on the bonds that back the currency issued by the RBI. Effectively, currency is an IOU (zero interest bearing) from the government. Now when the currency is extinguished effectively, the citizen writes-off the amount it had lent to the government.

The net effect is that black money held in high denomination currency that is extinguished will end up as government revenue as if it had been taxed at the rate of 100%. It is important to note that the amount involved is not small. If Rs 3 lakh crore of currency is extinguished that would be equivalent to a fiscal tightening of approximately 2% of GDP.

Why one should expect a tightening of credit conditions

Financing or credit conditions broadly refer to the spreads (above the benchmark rate) and the volume of credit available in different markets. Additionally, financing conditions are determined by the health (collateral and cash flows) of the borrower.

It is fairly obvious that financing conditions in the unregulated cash-based markets are expected to tighten (i.e., informal finance will become more expensive) as the currency that was used for transactions in these markets is now extinguished.

The tightening of credit conditions is unlikely to remain confined to the unregulated markets.

Credit conditions can also be expected to tighten in the formal sector. Real estate often serves as collateral for SME business lending. A drop in real estate value, which is widely expected, could reduce the ability to raise finance. A similar tightening of credit conditions can be expected in the household sector as collateral values and net worth is impaired.

Dealing with the impact on aggregate demand

Given that we are already at a point where aggregate demand is weak (i.e., there is an output gap in the economy) it is important to offset any further contractionary impulses. Monetary policy should be eased, the sooner the better, to offset the tightening of credit conditions. Borrowers should not be left facing higher borrowing costs.

From a fiscal perspective, it is important that the government's gains are not used to reduce the fiscal deficit, but should be offset by tax cuts or government spending. One potential way of spending this government windfall would be to transfer the funds to the people who have opened Jan Dhan accounts and positively leverage the Jan Dhan initiative to deliver a timely-economic stimulus. The math here is interesting.

There are 25 crore Jan Dhan accounts. If Rs 3 lakh crore of black money is extinguished, it can be used to give Rs 12,000 to every Jan Dhan account holder and therefore, result in a rise in discretionary spending. Alternatively, increased spending on infrastructure, of course, remains a straightforward option.